Value Investing and other odds and ends

Company Turnarounds are Hard

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Our conclusion is that, with few exceptions, when a management with a reputation for brilliance tackles a business with a reputation for poor fundamental economics, it is the reputation of the business that remains intact – Warren Buffett

Turnarounds seldom turn. – Warren Buffett

I’ll admit that I am interested in finding companies that are in a turnaround. I feel that if I can locate a company that will be successful, it will result in a high return on my investment. However, if you are experienced in the markets, or have worked for a company that is in a downward trend, you’ll know that it is very hard to turn a company around. I have worked for a company that I would classify as in a “death spiral” where revenue and profit are continually decreasing and it is very hard to change the course. This usually happens with a company that is in a market in decline and being overtaken substitute products or companies thus eliminating any advantages that the company had been relying upon.

So, how come I hunt in territories where Warren Buffett and others have warned investors against? Because for one, I think that it is an area that an investor can gain out-sized returns because of nature of the difficulty of investing in profitable turnarounds and two, the pool of competition is less (less investors hunting for these turnarounds). I’ll agree with Buffett that turnarounds seldom turn, but I think that criteria exists to use to increase the probability of positive returns. Peter Lynch divided stocks into 6 categories of which one was turnarounds. They are more difficult to analyze, but can be highly profitable – I think some of the difficulty arises because pure financial metrics will not help the investor and more qualitative research needs to be done in addition to the financial analysis.

Mismanagement but with strong assets in place – This is an ideal company turnaround situation because the base of the investment is for a new management team to efficiently utilize the assets of the business and create value. Usually the past history of the company is riddled with poor decisions by the executive team, and once a talented team can be placed into position, the company will become much more valuable. I have had some of my larger returns by investing in companies like this – Marvel Comics after their bankruptcy and during their initial transition into a movie and content company utilizing their strong portfolio of comic content. The Marvel asset was the rich content (Spiderman, Avengers, Daredevil, Thor etc..) and the management team executed a well designed plan to bring that content to the big screen and also sell merchandise licensing. Another recent winner is the investment in Infusystem ($INFU) as they had a strong asset but poor management. This story is still being played out, but has turned out well so far over the past year or two.

Technological/Market Disruption – This situation is much more difficult to overcome for a business and requires deep knowledge of the business, technology and/or the market to understand the dynamics. These companies are experiencing a secular and permanent change in market conditions which requires great change to effectively compete. Most companies are not effective in handling secular market changes, and falter. I would place a lot of failed companies in this category as it is so hard to turnaround a business if the market has drastically changed. Companies like Nortel (VoIP disruption), Radio Shack (Internet retailing), and Blackberry (Mobile Internet/Apps/Apple) are some good examples of businesses that were/are being disrupted. Another recent example is Yahoo – Yahoo has lost its footing over the last decade by changes in the market and Marissa Mayer is trying to turn it around – Jason Calacanis thinks it could still be done by Mayer at the helm but she needs to be given more time. This is a good company to watch to see if it can be done. I’ll lay out some criteria to use to identify the Death Spiral Company Turnarounds in another post, but it is extremely hard to identify.

My set of criteria to look for in identifying profitable investments in company turnarounds:

Mismanagement or cyclical problem as opposed to a technological disruption/obsolescence or secular change.

Very little or no debt – a large debt load can hamper or even kill a turnaround. A company needs time to change, and high debt loads do not allow for the needed time.

Small or Microcap company – It is easier to turnaround a smaller company with less employees, less products, less existing contracts in place etc… Large companies are much more difficult to change course.

Recent Management changes/overhauls – This is a good sign that things could be changing at the company if the company has had poor performance.

Activist investors start to buy shares and file activist SEC documents – activist shareholders can initiate change at the top and are a good catalyst.

Good assets in place that are not being utilized to full potential – I really try to identify companies that have strong and differentiated assets that just are not being used properly by management. I believe these situations are less risky and changes will eventually be made at the top to realize the full earnings power of the assets.

After an investment has been made, patience is very important. It will take time (depending on the timeline of turnaround) for these situations to change and work out. After all, a company is run by humans, and it takes us time to make the personnel, process, and investment changes necessary to grow.

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